Fund Forum: ESMA guidance on segregation at primes eagerly anticipated
Depository banks and prime brokers are eagerly awaiting the much anticipated decision by the European Securities and Markets Authority (ESMA) as to whether primes will be forced to segregate AIF assets from their own and other clients.
It has been reported that ESMA will meet on July 9 to formulate a common position, although given the imminence of AIFMD’s July 22 deadline, any decision on the matter could be pushed back until the autumn. “The prime brokers have asked ESMA to provide guidance in a Question and Answer paper on the subject. ESMA has asked them to provide evidence backing their claims that it will cause huge operational complexity and cost to the industry. The prime brokers argue that it does not provide any further level of investor protection. I also believe that ESMA will be directed by investor protection but I have not heard what their judgement is likely to be,” said one source.
Requiring prime brokers to segregate AIF assets could be a major challenge to their ability to re-hypothecate client collateral. “The prime brokers do not have the systems and mechanisms in place to enable them to re-hypothecate AIF assets. There is no system in place for them to require the sub-custodian to release assets for re-hypothecation. While segregation complicates matters, it is not fatal for the prime brokers as the majority of their clients will be domiciled in the Cayman Islands,” said one expert at a custodian bank, speaking at Fund Forum in Monte Carlo.
Article 21 of AIFMD subjects full-scope depository banks to strict liability for loss of assets. It also requires sub-custodians of depositories to segregate client assets from their own assets and those of non-AIF clients to enable the depository bank to clearly identify those assets.
Others go further and argue it risks seriously impeding the prime brokers. “It is a complete nightmare and will seriously hinder the prime brokers’ ability to re-hypothecate collateral. If ESMA were to impose segregation, the prime brokers would be forced to revamp their systems and processes, and this would take a very long time,” explained one AIFMD expert.
Despite criticism from prime brokers, many custodians are advocating segregation, pointing out they are simply following the rules as outlined in the Directive.
AIFMD is the latest in a long line of challenges to the traditional prime brokerage model. Firstly, hedge fund financing is being tightened up by prime brokers. A J.P. Morgan white paper in 2014 said attempts by prime brokers to reduce their dependency on short-term funding, hedge fund and investor restrictions on re-hypothecation of collateral and Basel III capital requirements, were all going to lead to an increase in the cost of financing. There is also a be strong possibility regulators in Europe could clamp-down on re-hypothecation whereby they will impose a 140% cap similar to that of the Securities and Exchange Commission (SEC).
Analysis in 2013 by Barclays Prime Services said managers would need to rationalise their borrowing practices, revisit appetite for leverage and reset their return on equity expectations to deal with the rising financing costs. The Barclays study added managers running illiquid strategies would be particularly hard-hit by the changes as prime brokers will be less willing to lend out illiquid assets due to the Basel III requirements on liquidity buffers. Prime brokers will therefore have to incur a portion of the cost of maintaining these buffers with their share of short-term, less liquid liabilities.